Bank of America Merrill Lynch Article June 2014 A Guide to Asset-Based Lending Businesses with increased liquidity and working capital needs may find an asset-based loan (ABL) to be an attractive alternative to conventional bank financing. More liquidity. Fewer restrictions. ABL can provide an attractive alternative to cash-flowbased bank financing by generating more liquidity in certain circumstances, and encouraging more efficient working capital management. It also subjects the borrower to fewer and less restrictive financial and negative covenants. Assetbased lending does this by utilizing a company s current and noncurrent assets as building blocks for its debt structure, focusing on liquidity and relying on collateral monitoring for comfort. ABL can provide an attractive alternative to cash-flow-based bank financing by generating more liquidity in certain circumstances, and encouraging more efficient working capital management. During the early 2000s, ABL experienced a paradigm shift. Mid-and large corporate borrowers saw the virtues of these structures, turning ABL from a Main Street-focused product to a Wall Street product. And because of its flexibility and adaptability across the credit spectrum, and the ability to pair it with a variety of junior capital products, the selection of an asset-based structure became increasingly one of choice rather than necessity. Four scenarios This guide examines the various types and features of this time-honored and evolving form of financing. But first, we look briefly at the four challenges that ABL helps businesses address: performance setbacks, growth initiatives, expansion possibilities and capital-markets opportunities. Take the first challenge: Companies experiencing performance-related issues financial deterioration, an industry downturn, operational issues often require funding while they work through them. ABL can provide the necessary breathing room and liquidity to enable management and its advisors to effect a turnaround. Next, businesses seeking to maximize their growth potential require funding for capital expenditures, working capital and high organic growth. Here too, ABL is a readily available avenue. Here too, ABL is a readily available avenue as it is more leverage tolerant and can help fill working capital in-balances created by fast growth. Organizations seeking to expand beyond organic growth initiatives often find they need to draw on third-party resources to fuel mergers, acquisitions, buyouts, entrance into new geographic arenas, and new product commercialization. In connection with this, they also can turn to the ABL market.
And finally, capital structure-related opportunities debt maturities, stock repurchases and dividends can frequently be met by use of asset-based loans. ABL facilities have less restrictive negative covenants, which enable companies to have the flexibility to undercut these transactions. Drivers of Asset Based Lending 1 2 3 4 Traditional ABLs What are the various types of asset-based loans available to middle-market businesses to provide the senior debt financing in these situations? Traditional products include revolving lines of credit, or revolvers, and term loans. In these structures, the lender takes a first-priority security interest in the assets pledged as collateral for the loan. Revolvers Performance Financial deterioration Industry downturn Operational issues Growth Capital expenditure needs Working capital needs High organic growth Expansion M&A LBO Geography/Product Capital Markets Debt maturities Stock repurchase Dividends Solutions Restructuring/DIP Traditional ABL Senior Stretch Junior Capital An asset-based loan is commonly structured as a revolving line of credit without a scheduled repayment, and on an interest-only basis. A revolver allows a company to borrow, repay and reborrow as needed over the life of the loan facility or agreement. The lender advances funds based on a percentage of the accounts receivable (normally 70 85%) and inventory. A borrower s inventory is typically based on the lesser of either 0 70% of the lower of cost, or market, depending on the category of inventory; or a percentage: A revolving credit facility can optimize the availability of working capital from the borrower s current asset base. e.g., 85% of the net orderly liquidation value determined by a third-party appraiser. When such assets convert to cash, the advances are repaid. A revolving credit facility can optimize the availability of working capital from the borrower s current asset base. Ineligible collateral is excluded from the borrowing base. Ineligible accounts receivable include past-due receivables, intercompany receivables and other lower-quality receivables. Ineligible inventory generally includes work in process, packaging materials or inventory at a subcontractor. However, depending on the industry, customer relationship and length of the production cycle, work-in-process may be considered eligible. A key structuring consideration in ABL is the borrower s level of liquidity measured by the level of excess availability under the revolver. Excess availability is the amount absent in an event of default that the borrower is entitled to borrow, and represents the excess of collateral availability over the amount of the loan and letters of credit outstanding, as well as any reserves established by the lender. The amount the asset-based lender is willing to lend increases if the amount of the assets securing the loan increases. In ABL the borrowing base not the facility size generally drives availability. A sufficient level of openings projected and excess availability will depend on the size of the business, working capital fluctuations and management s liquidity cushion comfort. A revolving line of credit typically has a term of two to five years and represents a committed form of capital. Periodic borrowing, reporting and collateral examinations are required, with such frequency depending on the credit profile of the borrower and its liquidity position. Certain borrowers may only have a springing financial covenant (i.e., a covenant such as fixed-charge coverage that it is subject to, if excess availability under its revolver drops below a certain level), which is referred to as covenant lite. Bank of America Business Capital currently provides revolvers of $10 million or more.
In the next section, we will address term loans. However, in certain circumstances, the advance against a borrower s fixed assets may be included in the revolver borrowing base rather than as a separate term loan. Term loans Like a revolver, a term loan is dependent on the composition and amount of available collateral and cash flow to support debt service. In a term loan facility, lenders are more willing to advance against machinery and equipment than real estate. The entire amount typically is advanced at closing, with repayment of principal and interest amortized over a period ranging from 5 to 15 years depending on the composition of the collateral or the unamortized balance due at maturity of the credit facility. In a term loan facility, lenders are more willing to advance against machinery and equipment than real estate. Term loans are typically amounts based on a certain percentage of the appraised net orderly liquidation value (NOLV) of the machinery and equipment (M&E) and the appraised fair market value (FMV) of the real estate. The NOLV is a third-party assessment of what can be realized over a period of typically up to six months against the M&E, and reflects the age and condition of the M&E as well as market conditions. For M&E, in some cases, a net forced liquidation value (FLV) or auction value may be more appropriate and/or the net proceeds may not exceed those realized in an orderly liquidation, since benefit of a more orderly sale may be outweighed by the higher expenses over a longer liquidation period. The real estate appraisal, obtained by the lender, must meet the standards of the federal Financial Institutions Reform, Recovery, and Enforcement Act. In contrast to M&E, which has a much shorter realization time frame, real estate may have a prospective holding period of several years. Lenders generally avoid lending against vacant, discounted operations. Typical advance rates against fixed assets comprising the term loan are up to 85% of the NOLV of the M&E, and up to 75% of the FMV of the real estate. For some fixed assets such as a chemical plant or other operations that would likely be sold in an intact sale, in the case of a failed non-operating entity, a liquidation value-in-place concept may apply. In these cases, the lender would typically apply a lower advance rate against the appraised value (e.g., 50 60%). Lenders typically define debt service coverage as earnings before interest, taxes, depreciation and amortization (EBITDA), less cash interest, cash taxes, unfinanced capital expenditures (CAPEX) and distributions (dividends) divided by scheduled principal payments on indebtedness. The standard is to look at these items on a trailing 12-month or fourquarter basis. (Certain add-backs to arrive at an adjusted EBITDA may be acceptable.) Pricing and amortization Unlike the cash flow market, where term loans based on cash flow are priced the same as a revolver based on cash flow, term loans most represent a mutual portion of the the total credit facility and are typically priced 25 to 50 basis points above the revolver. This pricing differential reflects the less liquid nature of these assets and the greater recovery risk inherent in a longer realization period. The amortization period of a term loan depends on the asset composition and the credit quality. M&E is typically amortized over five to seven years, while real estate may be amortized over 10 20 years, with the amortized principal due at the maturity of the credit facility (e.g., five years). Asset-based loans using real estate as collateral may have longer amortization periods than equipment loans because of the generally shorter economic life expectancy of equipment. Blended amortization schedules for the two asset classes are usually established. Asset-based loans using real estate as collateral may have longer amortization periods than equipment loans because of the generally shorter economic life expectancy of equipment.
At Bank of America Business Capital, asset-based term loans are acceptable, provided they generally do not exceed 40% of a borrower s gross borrowing capability (i.e., the amount eligible based on applying the advance rates to the borrower s current and non-current assets). In addition, the advance against real estate should not exceed 15% of the gross availability. If the borrower s credit facility requires syndication, in the asset-based lending market, there is generally an aversion to structures where the advance against fixed assets exceeds 30% of the gross availability. An ABL facility with fixed assets either advanced separately as a term loan or included as a reducing advance in the revolver (and with such reducing advance tantamount to the amortization those fixed assets would have as a term loan) may be structured as covenant-lite. However, to the extent that the fixed-asset advance is relied on (i.e., not covered by abundant excess availability), the borrower is typically subject to at least a fixed-charge coverage covenant. The value of intangibles Certain companies may have intellectual property with quantifiable value as collateral in an ABL structure. Such intellectual property could include brand names in a consumer products company, or products and their related tooling, patterns and designs in an industrial company. This value is often predicated on the cash flow generated by the business, and is established based on a relief from royalties concept (i.e., the value of the intellectual property is equal to the discounted present value of the royalty payments, which the company is excused from having to pay by virtue of its ownership of the intellectual property). Lenders prefer to see these valuations supported by values commanded in distressed sales in the market. Loan advances against intellectual property are typically 25 50% of the appraised value, and the portion of the overall loan secured by intangibles is often structured as a separate tranche, or portion, of the loan. Loan advances against intellectual property are typically 25 50% of the appraised value, and the portion of the overall loan secured by intangibles is often structured as a separate tranche, or portion, of the loan. Premium pricing is tantamount to cash flow market pricing on that portion of the facility, with the loan amortized over a period of up to three years. Structured advances Structured out-of-formula advances (structured advances) may be available for acquisitions, recapitalizations and other special situations. They may also be appropriate for short seasonal periods. A structured advance is a hybrid financing solution that falls between an asset-based loan and a cash-flow-based loan for companies that have more marginal free cash flows (e.g., due to high levels of unfinanced capital expenditures), because the borrower operates in a more cyclical industry or lacks all of the business value characteristics that would qualify the borrower as a cash flow lending candidate. Also known as an over-advance loan, it is structured with both asset-based and cash flowbased components, providing a higher level of leverage and delivering more capital up front than do loans based solely on typical ABL advances against collateral. This type of loan is often used when a company has demonstrated pro forma historical and projected ability to service its debt, including amortization of the structured advance. Common uses of a structured advance are in connection with leveraged buyouts, acquisitions and recapitalizations. While priced at a premium to a typical ABL facility on a blended cost-of-capital basis, the pricing is attractive compared to the cash flow lending market. Typically structured advances are amortized over a period not to exceed three years. There may be an excess cash flow (ECF) sweep applied to the over advance (e.g., 50% of ECF). FILO tranches First-in last-out (FILO) tranches are used within a revolving credit facility as another way of increasing the overall amount of the loan. FILO tranches started in the retail-finance segment of the market, but are now also being utilized for distributors and wholesalers and, even more recently, manufacturers.
Like a term loan, the FILO amount is advanced in full at the closing (i.e., first in ). Also, like a term loan, once repaid through an amortization of the FILO tranche, the FILO loan funds cannot be re-borrowed. The FILO loan is part of the senior credit facility and receives the benefit of a first lien on the company s assets. The advance under the FILO is typically an additional 5% of the borrower s eligible accounts receivable (A/R) and 5-10% of the NOLV of eligible inventory (thereby increasing the advance from 85% NOLV to 90% NOLV). FILO advance may be at the higher end of the value in cases where the overall credit facility is relatively large or where the borrower s credit profile is relatively strong. FILO tranches are generally amortized up to three years, but there may be a holiday prior to the start of amortization. FILO tranches are typically priced at a premium of 150 basis points or more above the revolver. Critical factors in structuring such tranches include debt service coverage, senior leverage and the level of excess availability. Pro forma debt service coverage on a historical and projected basis is more critical. And opening and projected availability should be greater than the FILO advance. Structuring considerations In providing intellectual property advances, structured advances and FILO tranches, lenders generally prefer to work with larger borrowers, similar to preferences for larger EBITDA companies held by cash flow lenders. As the size of the term loan or fixed-asset advance increases as a proportion of the gross availability or intellectual property advances, structured advances or FILO tranches are included in the facility, the level of senior debt/ebitda and total debt/ EBITDA draws more scrutiny from lenders. And in these situations, the financial covenant package can include both a fixed charge and leverage covenant. In a nutshell, middle-market companies with assets can use them as collateral against which to borrow. And they have numerous options when it comes to structuring an agreement. The following chart illustrates some of those options. The left-hand column lists debt categories based on priority of the lender s claim on assets. The center column shows traditional product types grouped on the basis of their degree of security for the lender. The right-hand column identifies several alternative loan products. Historically, structures available to middle-market companies were more plain vanilla, dominated by senior debt in combination with mezzanine financing. However, the market has evolved considerably. And ABL structures are highly flexible and adaptable in partnering with a wide variety of institutional term loan and junior capital providers to achieve an optimal financing structure. Bank of America Business Capital Financing Structures Available to Middle Market Companies Typical Middle Market Capital Structure Traditional Products/Structures Secured Alternative Products/Structures Priority of Claim on Assets First Last Senior Secured Debt Leverage up to 3.5x +/- (Sr. Secured Debt/EBITDA) Junior Debt/Traditional Subordinated Debt Leverage up to 5.0x +/- (Total Debt/EBITDA) Equity (~35% to 50% of capital structure) ABL Revolver Pro Rata (Cash Flow) Revolver and Term Loan Second Lien Term Loan Mezzanine Debt Convertible/Preferred Securities * Bifurcated Secured Term Loans have first lien on fixed assets and are used in conjunction with an ABL Revolver Institutional/Hybrid Term Loans Unsecured Bifurcated Secured Term Loan* Unitranche Pro Rata First Out/Last Out Coupon Only Mezzanine Debt Private High Yield Notes Borrower size, credit quality and industry sector greatly influence leverage and terms available within middle market Financing structures that pair ABL revolvers with term loans (i.e. traditional cash flow, bifurcated and unitranche) have become increasingly popular due to relative flexibility and favorable pricing As Business Development Companies (BDCs) remain active and aggressive across all loan segments, borrowers have increasingly tapped these non-traditional sources of debt capital by turning to alternative products and creative financing options With junior collateral providers focused on leverage both from a Debt/EBITDA stand point as well as a Loan/Enterprise Bank of America Merrill Lynch is the marketing name for the global banking and global markets businesses of Bank of America Corporation. Lending, derivatives, and other commercial banking activities are performed globally by banking affiliates of Bank of America Corporation, including Bank of America, N.A., member FDIC. Securities, strategic advisory, and other investment banking activities are performed globally by investment banking affiliates of Bank of America Corporation ( Investment Banking Affiliates ), including, in the United States, Merrill Lynch, Pierce, Fenner & Smith Incorporated and Merrill Lynch Professional Clearing Corp., both of which are registered brokerdealers and members of SIPC, and, in other jurisdictions, by locally registered entities. Merrill Lynch, Pierce, Fenner & Smith Incorporated and Merrill Lynch Professional Clearing Corp. are registered as futures commission merchants with the CFTC and are members of the NFA. Investment products offered by Investment Banking Affiliates:Are Not FDIC Insured May Lose Value Are Not Bank Guaranteed. 2014 Bank of America Corporation 03-14-1151